by Robert Teitelman | Published February 25, 2011 at 12:47 PM
Ever since the financial crisis revealed finance to be an unholy mess, an active school of thought has argued the case for narrow or utility banking. The idea is simple, the details complex. Essentially, it involves an updating of the old Glass-Steagall split: Banks that receive deposit insurance from the government should be forced to stick to traditional stay-on-the-books lending, which doesn't mean securitizations or, in some schemes, even selling loans into the loan markets. Everyone else would go forth without protection, but would be allowed, within limits, to play whatever high-risk game they wanted. The details vary widely. But while some adherents of this school have gotten a lot of attention -- Paul Volcker and Mervyn King belong to their ranks -- it has gotten short shrift from Congress and the White House. With the exception of the Volcker Rule, which may or may not have real bite, utility banking has lost again and again in terms of legislation and policy.

Indeed, the idea still lives, particularly since there remain unsettling uncertainties swirling around Dodd-Frank and other reform measures. That said, perhaps the most complete argument for utility banking -- and one of the most sophisticated takes on the financial crisis yet published -- has received less attention than it deserves: "A Call for Judgment: Sensible Finance for a Dynamic Economy," by Amar Bhidé, a professor at Tufts' Fletcher School of Law and Diplomacy. Why the relatively low profile? Well, the book comes out of an academic press, Oxford University Press, and the title lacks the panache of "Too Big to Fail" or "Failure of Capitalism." Bhidé is a well-known academic, but he's no Simon Johnson, Joseph Stiglitz, or even Richard Posner, semicelebrities available in one media or the other around the clock. But most significantly, the book's strengths -- its close historical reading of the evolution of finance -- may turn off some readers eager for drama, criminals and cabals. This is a problem, because an adequate interpretation of what occurred in 2008 lurks deep in the weeds of financial history -- both in the growth of the mortgage business, which Bethany McLean and Joseph Nocera handle quite nicely in "All the Devils Are Here," and in terms of banking and Wall Street, Bhidé's subject. Simplifying that history won't cut it.

Much of Bhidé's book involves a thoughtful reading of U.S. financial history. His argument is framed by a notion of how an idealized American economy should work, cobbled together from insights about venture capital and ideas from Friedrich Hayek. Bhidé argues that Wall Street and the banks must allocate capital for a decentralized economy driven by innovation. The genius of the system depends on what he calls, conjuring up Adam Smith and Hayek, "the decentralization of subjective judgment." Decentralization is necessary in a complex, fast-changing, innovative economy because it allows for flexibility and the efficient accumulation and processing of data. Bhidé contrasts this view with the adherence to what he calls codified or mechanistic models. "The half life of effective mechanistic models is quite short in a dynamic decentralized economy," he writes. His model for subjective judgment is the venture capitalist who makes bets on a future that remains eternally elusive. VC firms come to opportunities with structure and routine, but the process involves a loose working arrangement between partners who, as a group, have the autonomy to make one-off or gut decisions, often based on long relationships and deep knowledge. VC firms are thus, by their very nature, small and loosely organized.

Bhidé argues that the VC process isn't all that different from traditional bank lending, which depends on deep knowledge of borrowers and their businesses and involves long relationship. Banks are not like normal corporations, he argues. There is a real price to be paid for trying to automate or mechanize lending decisions, each of which is a unique, one-off judgment. This creates diseconomies of scale. "Beyond a point, however, the costs of managing large organizations outweigh the benefits -- and that point is reached much sooner with finance than in many 'real economy' industries," he writes. "One important reason is that financiers have to make judgments about individual deals or loans, rather than about a large class of nearly identical situations or a high volume process." Financial managers also suffer problems of scale. Senior managers in industrial corporations don't have to know how a product is made; managers can be effectively judged by some set goal, like output or profits. But financial decisions add judgments about risk to the mix. Supervisors require a deep understanding of products and customers to oversee such an operation. This becomes increasingly difficult as firms expand and diversify.

Bhidé is well aware that much of the recent history of finance involves the attempt to quantify or mechanize those judgments: This involves everything from the rise of the efficient-market hypothesis to modern financial innovations like the Black-Scholes-Merton option-pricing model to the capital-asset-pricing model to the development of securitization. He is skeptical about all of them (he bemoans the replacement, and downgrading, of the concept of "uncertainty," arising from one-off situations, and used by Frank Knight and John Maynard Keynes, with glibly "quantifiable" probability), particularly the belief that you can plug in a few numbers and extract an answer that is meaningful (his discussion of options-pricing is withering). In short, many of the old fears about size and risk fell away beginning in the late '60s.

There's a lot to this argument, some of which is debatable, much of which is illuminating. Bhidé is particularly concerned with what he calls the development of arm's length markets rather than ongoing relationships in finance. One prominent theme is the evolution of governance in finance, which he argues has become increasingly arm's length as well, in part paradoxically because of the securities reform legislation of the '30s. Here's the sequence: Securities reforms, with their emphasis on transparency and disclosure, eventually favored the development of highly liquid markets. As these markets developed, particularly in equities, institutions took over the game. But that liquidity and the decline of transaction costs allowed institutions to build broadly diverse portfolios and to move easily in and out of the markets. The result was an increasingly arm's length relationship with companies, which undermined the monitoring required of the ascendant orthodoxy of shareholder democracy. But Bhidé goes further. He argues that that situation created hidden costs, one of which is alienation between managers and shareholders. On one hand, the market seems "unfair" or arbitrary to executives, who, in turn, feel the need to protect the company (and themselves) against investors. On the other hand, investors view their stakes as simply one sliver of a broad portfolio. Accountability breaks down on both sides.

Large commercial banks went the public route quite early; Wall Street firms remained partnerships, with their intimate and risk-averse governance arrangements, until the late '60s, with Goldman, Sachs & Co. finally succumbing in 1999. The arm's length phenomenon has certainly taken hold, and it's been accompanied by much that Bhidé disdains: willy-nilly diversification, mushrooming scale, a lack of oversight. Traditional credit cultures have long since broken down. The personal customer-bank relationship was replaced by the arm's length process of credit scoring, trading or securitization. Bhidé recounts with some detail the checkered history of banking in the U.S., through the Great Depression and into the post-war years of prosperity and growth. He tracks the breakdown of the New Deal consensus on banking -- admitting in some cases that some changes were rational, while others had unintended consequences.

All this is prelude -- and it's quite a long one -- to the financial crisis, which hangs over every discussion as the disastrous end point to which all trends culminate. Bhidé is far too nuanced to declare every decision made to be another step on the road to disaster, but that's how his discussion often feels (though he thinks that by 2002 the housing bubble might still have been avoided, he believes disaster was "an accident waiting to happen"). As you work your way toward 2008, you wonder: When will he tie all this together with policy prescriptions? He does in the final chapter, rolling out his notion of utility banking and arguing that, in terms of innovation, banks should return to the '80s, before derivatives and securitization. It all seems mildly anticlimactic. Not that he hasn't thought deeply about these proposals and built his case carefully. But after all this close examination of the historical twists and turns, and odd excursions, of banking in America, the notion that a relatively simple division between utility and nonutility banks would work for a decent period of time without producing its own wayward consequences strikes one as implausible.

The obvious observations can be made about this utility banking notion. True, it would certainly help the too-big-to-fail problem, and it might push off, at least for awhile, the seemingly insolvable issue of regulatory capture. It's more difficult to tell what effect a fundamental split in finance like this would have on economic growth. Bhidé implies that a tightly controlled and highly regulated banking system effectively fueled the corporate machinery in the high-growth '50s and '60s and therefore would today. But that was a very different economic era, with a very different economy, and a U.S. confronting a radically changed world. Bhidé's own history underscores how profound the gap is.

And there are other problems with his utility bank model. Banks were driven toward consolidation, diversification and greater leverage by the extensive disintermediation that took place in the '70s and '80s, in part from money markets, in part from Wall Street. Deregulation arguably began as an attempt by regulators to restore some growth to banks that were losing corporate clients to the markets and consumers to better-returning nonbank providers. Why would utility banks not suffer that same fate, particularly if they remained public entities? (Or is he suggesting that they be banned from a public listing?) Banks would clearly suffer in terms of share price compared to more lightly regulated, transactionally driven financial firms. Why wouldn't utility banks quickly settle into a kind of backwater, attracting less talented employees and decaying over time? On the other side of the fence, what would keep less regulated firms from developing into systemic threats? After all, consumer deposits were not at risk in the crisis; and they would be presumably safe in the utility bank sector in the event of a breakdown. But that does not mean that a large, interconnected firm could still not fail and bring down others with it. Bhidé's utility banks wall off an important sector of finance, it's true, but that leaves a still-ample bestiary of firms and funds, some systemically important.

In the end utility banks have trouble avoiding the chronic problem of partial regulation, found in other industries from healthcare to utilities to telecom. The solution is to either liberate the regulated entity to effectively compete or broaden regulation. Both scenarios are problematic. It's very hard to take this deregulated genie and stuff him back into his bottle.